The Securities and Exchange Commission’s increasing scrutiny of special purpose acquisition companies and guidance on how to account for warrants are slowing deal activity for firms.
Last week, the SEC issued a staff statement on the accounting and financial reporting considerations for SPACs, also known as “blank-check companies.” The SEC basically said that warrants, which are typically issued to early investors in such companies, might not be considered as equity instruments and would instead be accounted for as liabilities measured at fair value on a company’s books (see story).
SPACs have become an increasingly popular way for companies to go public in recent years. With a SPAC, investors essentially create a shell company to raise money via an IPO, but with the main goal of acquiring another company. Companies that have used SPACs to go public include DraftKings, Virgin Galactic, Opendoor and Nikola Motor, according to CNBC. With the guidance following shortly on the heels of a warning on March 31 from the SEC about the financial reporting and auditing considerations for companies merging with SPACs, and another SEC statement that same day about accounting, financial reporting and governance issues pertaining to SPACs, the market for SPACs is suddenly shifting to a more cautious footing. Accounting and consulting firms that have been helping their clients prepare for a SPAC now have to take a step back and reevaluate their approach.
Joshua Roberts/Bloomberg
“The statement they came out with references two terms within those instruments that basically would result in a lot of these warrant instruments being liabilities,” said Demetrios Frangiskatos, co-leader of BDO’s SPAC assurance practice. “They would have a liability classification vs. equity. It’s actually been a big to-do over the last several days, evaluating the statement, what it means for the instruments that are already outstanding, that have had their IPO and their filings. Firms are going through them and evaluating whether the change in accounting is going to result in a restatement. What the guidance basically tells you is those instruments can no longer sit within the equity structure of the balance sheet. They have to be marked to market over a period and the change in their fair value goes to the profit and loss statement. That is going to impact basically all the SPACs that have occurred, and the SPAC transactions where the equity instruments are still with the operating company and they haven’t been exercised or redeemed. It’s a pretty big deal.”
The SEC statement could change the accounting for many of the companies. “It appears a significant amount of these will have to be reevaluated and potentially restated,” said Frangiskatos.
So far, the guidance has come from the SEC’s Division of Corporation Finance, but if the SEC uncovers abuses, that could get its enforcement unit involved. “Given the explosion of SPACs over the last 15 months and the risks they present to investors, the Division of Enforcement is likely focused on investigating potential wrongdoing associated with the risks and challenges highlighted by Corp Fin and the Acting Chief Accountant, and will move quickly to recommend enforcement actions if necessary,” said Caitlyn Campbell, a former enforcement attorney at the SEC and now a partner at the international law firm McDermott Will & Emery.
The series of SEC warnings and statements appear to be slowing down SPAC deal activity, but it’s probably not the only factor. “The market has slowed down a little bit for a variety of reasons, and maybe it was a needed slowdown,” said Frangiskatos. “There was such a high volume for a period of time, and obviously this guidance has slowed it down as well because the ones that want to file have to evaluate the instruments, maybe change the terms, make sure their accounting firm is comfortable with the accounting classification.”
Companies need to evaluate the liability vs. equity accounting treatment and their auditing firm needs to know the fair value. “It’s going to require a certain amount of work,” said Frangiskatos. “This is slowing down the sector, at least right now.”
Until the latest piece of guidance last week from the SEC, the SPAC boom seemed to be peaking. “The pace that it was going at for a period of time is a pace that it’s probably hard to see sustained long term,” said Frangiskatos. The market was already starting to show signs of a slowdown earlier this month. “There’s been such a high volume going through the SEC, we heard some of the reviews may be taking a little bit longer, which is no surprise, so maybe that’s part of it,” he added.
He noted that it takes time for operating companies to get ready and get their audits done in accordance with Public Company Accounting Oversight Board standards so they can be acquired by a SPAC and subsequently “de-SPAC” and become operating companies again. “Obviously all these private companies didn’t necessarily have getting into the capital markets as part of their short-term plans,” said Frangiskatos. “Some of them have pivoted because of this shift in the market.”
The SEC previously warned investors in March about SPACs promoted by celebrities after athletes like Shaquille O’Neal and Serena Williams became associated with various companies. “However, celebrity involvement in a SPAC does not mean that the investment in a particular SPAC or SPACs generally is appropriate for all investors,” said the SEC. “Celebrities, like anyone else, can be lured into participating in a risky investment or may be better able to sustain the risk of loss.”
The SEC also issued guidance in December about disclosures involving SPACs. “They put out guidance on disclosures, which is making sure there’s robust disclosure on how the deals are structured, making sure people understand what the sponsor and the banker and what the strategy is, etc.,” said Frangiskatos. “They’ve really just tried to make sure that the integrity of the process is maintained and that these operating companies know what they’re in store for when the de-SPAC happens.”
Companies need to be aware of the auditing implications for SPACs, and firms have been helping them prepare for those. “We started seeing this wave several months ago where companies either had AICPA opinions and were asking us to do enough work where they could have a PCAOB opinion so they could be ready for a SPAC to get audited,” said Frangiskatos. “We continued to see that wave and momentum come in over the last couple of months, where they want to have multiple years of audit opinions on the PCAOB standards. If the SPAC was an exit strategy, they want to be prepared for that. ”
To prepare a client for a SPAC deal, firms like BDO need to deal with both the audit and accounting side, especially in light of all the SEC guidance.
“There are multiple sides to the house,” said Frangiskatos. “There’s one side of the house where there’s a company that’s either been audited before, maybe not to PCAOB standards, or maybe they were audited by a firm that wasn’t registered, and they bring in our team to come in and to do that work, go through and review and audit their financial statements, evaluate the GAAP, make sure it’s up to PCAOB standards, evaluate the disclosures and things of that sort. But we have another side of the house which does IPO readiness and prepares a company with financial reporting expertise and help so they can develop processes and infrastructure so they can be ready to do 10-K’s and 10-Q’s in case a SPAC happens. At the same time, those teams will do a gap analysis and evaluate where there may be gaps in their operating structure from a governance, financial reporting and technology standpoint and help the management and investment teams through that so that they know these are the things you need to be thinking about, here’s what your timeline is going to look like, here’s what kind of reporting you’ll need, here are the types of things public companies have, here is where you have some challenges. Our team will do an assessment, and where appropriate, they’ll come in and help. That’s becoming more and more common because some companies haven’t made investments to become public companies, so they’ve got to ramp up quickly. Getting our expertise in there to help them out has been extremely valuable in bridging that gap.”
Until recently, the IPO market seemed to have shifted more toward SPACs, but that may be changing now with all the SEC guidance that’s been coming out in recent months. “There’s a whole universe of important things they need to be thinking about, and when we’re working with companies we’re trying to remind them that you really need to prepare for all this so that when you go prime time and hit the public markets you really have developed the right skill sets,” said Frangiskatos. “In some cases they’re using our accounting and advisory team to help them get to that point and bridge some of that gap while they continue to make those investments. It’s a very interesting time and there are quite a few challenges that our teams are working through and helping these teams to get ready to go to market.”
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